A Pragmatic Approach to Local Investment

(this article appeared in Room 151 on 13th August)

Local Investment

LGPS Funds are starting to grapple with the complexities of increasing local investment in line with the Pension Schemes bill.  Local is defined as ‘broadly local or regional to the AA (Administering Authority) or Pool’.  That is easier for the geographically distinct pools (Wales, London CIV), less so for those with broader spreads.  Depending on where ACCESS and Brunel AAs go to, some pools may in future be virtually UK wide anyway.  Anyone for Berwick to Bodmin or Canterbury to Carlisle?   

The Government has left itself a little wriggle-room by using the word ‘broadly’, and I suspect the practical answer will be that local means UK.  It isn’t sensible for some but not others to restrict themselves geographically, if only for reasons of diversification.  

The sourcing of new opportunities has been a subject of debate.  The Government’s high-level vision is that AAs and Pools together will work with local mayors and authorities.  These links will initially come through the local AAs, because the Pools do not have them.  AAs may find themselves dealing with multiple authorities and in some cases ones which do not yet exist.  

Do the AAs have the distinct investment skillset and resources required to triage the pipeline of opportunities?  Some larger AAs undoubtedly do, but the average shire or borough AA does not.  And investment skills at AAs generally are likely to decline after implementation has moved to the Pools.  Solutions will undoubtedly emerge, but it seems the triage burden will inevitably fall on the Pools rather than the AAs.

The Government’s template does not include an allocation to local investments.  Perhaps that is right, because local investments will cover a wide spectrum, from micro scale enterprises to large infrastructure projects.  But the Pools so far have chosen to go with separate funds for their local or impact type investments.  Border To Coast’s UK Opportunities Fund, which invests across a range of asset classes, is an example.  But where will this go in the Government’s template?  If the answer is the catch-all Other Alternatives, that will not help transparency. 

I would prefer the Pools to include local investments within their mainstream products.  For reporting purposes local assets could be marked as such, but in principle they should earn their places in each Pool sub-fund on their own merit.  It would, however, be necessary to monitor both the geographic spread and the non-financial impact to ensure that investment didn’t just go to the major conurbations.

The bulk of future local investments will be in one of two broad types:  infrastructure and real estate, both of which aim to improve the ability of an area to prosper; and lending to SME and venture cap, which are more targeted at helping specific businesses to grow.  

They are very different.  The first two tend to be larger scale and a better match for Pools managing at least £50billion of assets.  Due diligence resources and fees become less of a problem.  

In contrast, the last two are relatively small scale.  Venture cap is by definition investment into small companies.  It requires investors with a distinct mind-set, a tolerance for failure, and an ability to make judgements on limited or minimal information.  The story of how today’s Silicon Valley behemoths began is highly instructive.*  Do the Pools have the right culture to be successful?

I believe the LGPS could maximise their impact by lending to small and medium size enterprises (SMEs).  Banks have largely drawn back from this business because of Basel II’s capital adequacy requirements.  Private credit is expensive for the borrower.  Private equity usually involves handing over control.  

The consequence is a gap which the LGPS could fill and have an immediate impact on local economies.  However, there is a scale mismatch because deal sizes tend to be in the £5 to £20m size, and traditional due diligence is just as expensive as for large ones.  The explosive growth in the uses of AI has the potential to bring this cost down in due course, but we are not there yet.

My conclusion in this area is that the Pools should indeed be investing in all these areas. Infrastructure and real estate are easier in practice, but SME lending or venture cap may well have more impact.  At least to begin with in all asset classes they will be forced to outsource to external fund managers, even though that is not the Government’s preferred route.  In specialist areas such as SME lending or venture cap, they may do better to do that in the longer term too.

There is also a requirement to report on local investments.  This will almost certainly have to be done by the pool, as much ESG reporting already is.  But it does require AAs to adopt a common philosophy when investing locally.

I will return finally to a strategic question.  The Government makes it clear that it believes most local investment will be through private markets.  However, the illiquidity premium (i.e., the premise that investors receive a higher return for locking up their investments) is under question.  Many believe that to gain higher returns from illiquids investors will need to take specific risk, just as in public markets.

At the same time, the lack of liquidity represents an opportunity cost and reduces flexibility, and there is a level where these costs outweigh the return benefits.  For some LGPS funds that may not be far away.

*Sebastian Mallaby’s ‘The Power Law’  Allen Lane 2022  £20.00